Study Unlocks What Makes Groupon Work for Businesses

CHICAGO ( TheStreet) -- When Groupon ( GRPN) was launched four years ago, it created an entirely new model for marketing small businesses. Although the site was ostensibly a discount service aimed at saving its users money and exposing them to new experiences, it also gave independent businesses a chance to reach a wider base of potential customers. And that customer base grew exponentially, along with Groupon itself.

But such a dazzling rise was impossible to sustain long term. Groupon has had to fend off competition from copycat sites such as LivingSocial and Amazon Local ( AMZN), and its stock price has tumbled 90% since the company's IPO last year, reflecting general uncertainty about the long-term success of the daily-deal business model.

The business press has been filled with big-picture analysis of Groupon's travails and delivered less recent analysis of the small picture: whether Groupon and its rivals deliver for the businesses that offer the deals. Are daily deals a great marketing opportunity? Or a risky bet that often doesn't pay off?

One of the few researchers examining the daily deal market from that perspective is Utpal Dholakia, a professor of management at Rice University's Jones Graduate School of Business. His latest study, How Businesses Fare With Daily Deals As They Gain Experience, surveyed more than 600 small businesses across the country about their experiences.

The paper is a must-read for any business owner considering signing up with a deal site, offering a wealth of specific details: how likely they are to make a profit from a deal; the percentage of people who redeem a deal and become repeat customers; and which types of businesses see the best return on their investment.

"Many small-business owners don't think through the reasoning and implications of offering daily deals, and then they get hurt," Dholakia says. "I want to help them increase their chances of success."

The study breaks down the key metrics small businesses need to know before signing up. Overall, about 60% of the deals offered were profitable for the business that offered them (roughly 20% of the businesses broke even on their deals; the rest lost money). About 80% of the people who redeemed the deals were new customers, and about 20% ended up patronizing the business again. About one-third spent more than the deal value (often a key factor in whether the offer was profitable).

Remarkably, a company's marketing budget (or lack thereof) made no difference: Companies that spent nothing on marketing were just as likely to have a successful promotion as those that spent a lot of money advertising. The size and age of the business also had little to no impact on overall profitability.

One differentiator was the number of deals offered: while only 45% of those business offering their first deal reported making a profit, 76% of deals were profitable for those businesses that had run seven or more. Clearly, there is a learning curve when it comes to offering deals, and those who master the right mix see a payoff.

"Learning goes on at multiple levels," Dholakia says. "Merchants start to offer the kinds of deals that hurt their margins less, they figure out the efficiencies of providing service and they improve their marketing to deal users." Another notable finding was that offering multiple deals over time did not seem to lead to diminishing returns: the same percentage of new customers (roughly 80%) bought a deal whether it was the first time being offered or the seventh.

Another striking finding was the difference in profitability between different types of companies. The businesses reporting the highest rate of profitability from deals were photographers (75%), health and fitness services (69%), tourism-related services (68%) and doctors and dentists (67%). Deals offered by restaurants and bars (44% profitable), and cleaning services (27% profitable) were much less likely to be successful.

"In cases where businesses have low variable costs, such as a yoga studio, profitable deals are more likely than in cases where the variable costs for the business are high, such a restaurant," Dholakia says. "Other factors which could make a difference are the extent to which the business is able to cross-sell other higher-margin products or services and the extent to which they are able to convert first-time users into repeat buyers." It may be easier to convince a person who tried out a fitness class to sign up for a full session than it is for a restaurant owner to lure back diners who stopped in only because they wanted a half-price meal.

Ultimately, every small business must determine their ultimate goal: Are they offering a deal to spread the word about a brand-new business? To bring in customers during off-hours? To offer a relatively inexpensive service but aggressively upsell other products?

Business owners must also do their own due diligence, understanding the fine print in their agreement with a daily deal site (on average, sites split the revenue from every deal sold 50-50 with the business offering it). Business that run repeat deals may benefit from trying out different sites and/or negotiating more favorable revenue sharing.

Groupon's stock price may be in free-fall, but its business model has already proven to be a success for many independent companies, as long as they structure deals that pay off for both them and bargain-hunters.

This commentary comes from an independent investor or market observer as part of TheStreet guest contributor program. The views expressed are those of the author and do not necessarily represent the views of TheStreet or its management.

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